Did We Have a Crisis Because Deficits Were Too Small?

In comments to the previous post on fiscal policy, Steve Roth points to a couple posts from his own (excellent) blog pointing to a similar argument by Randy Wray, that falling federal debt-GDP ratios nominal volumes of government debt have consistently preceded financial crises historically.

Also in comments, Chris Mealy asks,

Isn’t the idea that sufficient government debts will prevent phony safe assets and the financial crises they lead to?

Right, exactly!
A couple years ago, VoxEU ran several good pieces making exactly this argument — that it was the lack of sufficient government debt that spurred the growth of mortgage securitization. Here is one:

The increased demand for US government debt by emerging economy central banks led to lower yields, thus forcing those savers in the OECD countries who would normally have held government assets to frantically “search for returns”. … The AAA tranches on securitised US mortgages … seemed to provide the safety plus a “yield pick up” without any risk… 

The key technology that permitted the transformation of US mortgages into safe liquid assets was securitisation. … The massive buying of US government paper by emerging market central banks had displaced other investors whose preference previously had been for safe, short-term, liquid assets.  … The excess demand for short-term, safe, liquid assets created by emerging economies’ accumulation of reserves could not have been satisfied by the securitisation of US mortgages (and consumer credit) without massive credit and liquidity “enhancements” by the banking system. … 

Looking forward, this analysis implies that the current (smaller but still sizeable) US current account deficit should not lead to similar asset supply and demand mismatches since US households are now starting to save and it is the US government which is running the deficit, thus supplying exactly the kind of assets needed

And here is another, from an impeccably mainstream author:

The entire world had an insatiable demand for safe debt instruments – including foreign central banks and investors, but also many US financial institutions. This put enormous pressure on the US financial system… The financial sector was able to create micro-AAA assets from the securitisation of lower quality ones, but at the cost of exposing the system to a panic… In this view, the surge of safe-asset demand was a key factor behind the rise in leverage and macroeconomic risk concentration in financial institutions… These institutions sought the profits generated from bridging the gap between this rise in demand and the expansion of its natural supply. … 

[Once the crisis began], the underlying structural deficit of safe assets worsened as the … triple-A assets from the securitisation industry dried up and the spike in perceived uncertainty further increased demand for these assets. Safe interest rates plummeted to record low levels. … Global imbalances and their feared sudden reversal never played a significant role for the US during this deep crisis. In fact, the worse things became, the more domestic and foreign investors ran to US Treasuries for cover and treasury rates plummeted (and the dollar appreciated). … 

One approach to addressing these issues prospectively would be for governments to explicitly bear a greater share of the systemic risk. … If the governments in asset-producing countries were to do it directly, then they would have to issue bonds beyond their fiscal needs.

The logic is very clear and, to me at least, compelling: For a variety of reasons (including but not limited to reserve accumulation by developing-country central banks) there was an increase in demand for safe, liquid assets, the private supply of which is generally inelastic. The excess demand pushed up the price of the existing stock of safe assets (especially Treasuries), and increased pressure to develop substitutes. (This went beyond the usual pressure to develop new methods of producing any good with a rising price, since a number of financial actors have some minimum yield — i.e. maximum price — of safe assets as a condition of their continued existence.) Mortgage-backed securities were thought to be such substitutes. Once the technology of securitization was developed, you also had a rise in mortgage lending and the supply of MBSs continued growing under its own momentum; but in this story, the original impetus came unequivocally from the demand for substitutes for scarce government debt. It’s very hard to avoid the conclusion that if the US government had only issued more debt in the decade before the crisis, the housing bubble and subsequent crash would have been much milder.
While we’re at it, I can resist reposting the old post where I first mentioned this stuff:
A focus on cyclical stabilization assumes that there is no systematic long-term divergence between aggregate supply and aggregate demand. But Keynes believed that there was a secular tendency toward stagnation in advanced capitalist economies, so that maintaining full employment meant not just using public expenditure to stabilize private investment demand, but to incrementally replace it.
Another way of looking at this is that the steady shift from small-scale to industrial production implies a growing weight of illiquid assets in the form of fixed capital. There is not, however, any corresponding long-term increase in the demand for illiquid liabilities. If anything, the sociological patterns of capitalism point the other way, as industrial dynasties whose social existence was linked to particular enterprises have been steadily replaced by rentiers. The whole line of financial innovations from the first joint-stock companies to the recent securitization boom have been attempts to bridge this gap. But this requires ever-deepening financialization, with all the social waste and instability that implies.
It’s the government’s ability to issue liabilities backed by the whole economic output that makes it uniquely able to satisfy the demands of wealth-holders for liquid assets. In the functional finance tradition going back to Lerner, modern states do not possess a budget constraint in the same way households or firms do. Public borrowing has nothing to do with “funding” spending, it’s all about how much government debt the authorities want the banking system to hold. If the demand for safe, liquid assets rises secularly over time, so should government borrowing.
From this point of view, one important source of the recent financial crisis was the surpluses of the 1990s, and insufficient borrowing by the US government in general. By restricting the supply of Treasuries, this excessive fiscal restraint spurred the creation of private sector substitutes purporting to offer similar liquidity properties, in the form of various asset-backed securities. But these new financial assets remained at bottom claims on specific illiquid real assets and their liquidity remained vulnerable to shifts in (expectations of) the value of those assets.
The response to the crisis in 2008 then consists of the Fed retroactively correcting the undersupply of government liabilities by engaging in a wholesale swap of public for private liabilities, leaving banks (and liquidity-demanding wealth owners) holding government liabilities instead of private financial assets. The increase in public debt wasn’t an unfortunate side-effect of the solution to the financial crisis, it was the solution.
Along the same lines, I sometimes wonder how much the huge proportion of government debt on bank balance sheets — 75 percent of assets in 1945 vs. 1.5 percent in 2005 — contributed to the financial stability of the immediate postwar era. With that many safe assets sloshing around, it didn’t take financial engineering or speculative bubbles to convince banks to hold claims on fixed capital and housing. But as the supply of government debt has dwindled the inducements to hold other assets have had to grow increasingly garish.
From which I conclude that ever-increasing government deficits may in fact be better Keynesianism – theoretically, historically and pragmatically – than countercyclical demand management.
(What’s striking to me, rereading this now, is that when I wrote it I had not read any Leijonhufvud. Yet the argument that capitalism suffers from a chronic oversupply of long, illiquid assets is one of the central messages of Keynesian Economics and the Economics of Keynes — “no mortal being can hold land to maturity,” etc. I got the idea from Minsky, I suppose, or maybe from Michael Perelman, who are both very clear that the specific institutions of capitalism are in many ways in deep tension with the development of long-lived capital goods.)

UPDATE: Hey look, The Economist agrees. I think that means it’s time to move on.

UPDATE 2: So does Joe Weisenthal at the The Business Insider. His argument (and Stephanie Kelton’s) is different from the one here — it focuses on the fact that net savings across sectors have to sum to zero, as opposed to the government’s advantage in providing liquidity. But the fundamental point is the same, that the important thing about the government fiscal position is the implications it has for private balance sheets.

UPDATE 3: Steve R. points out that I misread his posts — Wray’s argument is about the nominal volume of federal debt outstanding, not the debt-GDP ratio. Hmm. I’m not sure I buy that relationship as evidence of anything … but it’s still good to see that Wray is asking this question. Steve also points to this paper, which looks very interesting.